Italy was dragged deeper into Europe's debt crisis on Monday as its borrowing costs soared to their highest level since the euro was created.

The yield, or interest rate, on 10-year Italian bonds leapt to 6.66% on Monday, as Silvio Berlusconi's government prepared for a key vote on the country's public finances on Tuesday. Analysts warned that Italian yields were now approaching the "danger area" where a bailout looks a real risk.

Stock markets around Europe fell sharply, amid concern that the debt deal hammered out in Brussels less than two weeks ago will not fix the crisis.

"The current feeling is that Italy is too large to bail out with the current mechanisms in place, should Greek-like turmoil spread to Italy," warned Peter O'Flanagan of Clear Currency. The FTSE 100 was down 1.6%, at 5,435. Banks bore the brunt of the falls – with Lloyds Banking Group down 4.7%, Barclays down 3.4% and Royal Bank of Scotland down 3.2%.The French CAC and the German DAX also fell, by 2.1% and 1.9% respectively.

The Italian debt costs are likely to worry markets the most, amid fears that the debt problems of the eurozone's periphery could be heading towards the centre, to countries with much larger and less manageable debt piles.

There were suggestions that a change at the top of Italian politics might reassure the markets about Italy's debt situation.

"There has been a lot of speculation that a different leader would lead to a sharp retraction in Italian bond yields. That might well be the case in the short term but considering the starting debt position, the economic outlook and the general lack of confidence in Italian debt it promises to be a challenging period of time for any Italian leader," said Gary Jenkins at Evolution Securities.

The negotiations between George Papandreou and Antonis Samaras over Greece's new unity government were set to resume on Monday morning, with the name of the next prime minister expected to be announced before the end of the day.

In France, prime minister Francois Fillon is expected to outline an €8bn package of cuts to assuage fears over the country's deficit and credit rating. A move to a higher French retirement age of 62 is expected to be brought forward to 2016 or 2017, rather than 2018. Automatic rises in welfare benefits could also be hit, Le Figaro has suggested, while there could be a rise in VAT in certain areas. Large companies could face a higher tax rate, meanwhile.

Jane Foley at Rabobank said: "Last month Moody's warned that France is among the Euro-area nations most likely to be downgraded in a stressed economic scenario. If France were to lose its AAA credit rating, the cost of banks' funding would likely come under increased pressure which in turn would undermine confidence in the French bond market even more. Add on the fact that a presidential election has been set for May next year and it is clear that the stakes for the French government are extremely high."

As Italy finds itself in the same ante-room to bankruptcy already used by Greece, Ireland and Portgual, so the spotlight falls back on Germany and the Berlin government's adoption of the moral high ground